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Private Equity Premium and Aggregate Uncertainty in a Model of Uninsurable Investment Risk

Francisco Covas () and Shigeru Fujita

The B.E. Journal of Macroeconomics, 2011, vol. 11, issue 1, 1-36

Abstract: This paper studies the quantitative properties of a general equilibrium model where a continuum of heterogeneous entrepreneurs are subject to aggregate as well as idiosyncratic risks under the presence of a borrowing constraint. The calibrated model matches the highly skewed wealth and income distributions of entrepreneurs. We provide an accurate solution to the model despite significant nonlinearities that are absent in the economy with uninsurable labor income risk. The model is capable of generating the average private equity premium of roughly 3% and a low risk-free rate. The model also produces procyclicality of the risk-free rate and countercyclicality of the private equity premium. The countercyclicality of the equity premium is largely driven by tightening (loosening) of financing constraints during recessions (booms).

Date: 2011
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